Chapter 11
The Corporate Taxpayer
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
11-2
The Corporate Taxpayer
Identify legal characteristics of corporations
Compute the dividends-received deduction
Prepare a Schedule M-1 reconciliation
Compute regular tax on corporate income
Discuss corporate AMT
Describe payment and filing requirements
Explain why dividends are taxed twice
Discuss the incidence of the corporate income tax
11-3
Corporation Legal Characteristics
Limited liability of shareholders
Owners of closely-held corporations often are required to personally
guarantee repayment of debt
Licensed professionals must still carry malpractice insurance
Unlimited life
Legal existence not affected by changes in ownership
Free transferability of interests
Through regulated markets with maximum
convenience and minimal transaction cost
For closely-held corporations, a buy-sell
agreement may prevent transferability
Centralized management
11-4
Affiliated Groups and Consolidations
Affiliated groups = a parent corporation that directly
owns at least 80% of at least one domestic
subsidiary + all other domestic subsidiaries that
are 80% owned within the group
Affiliated groups may elect to file a consolidated
tax return - applies to all members of affiliated
group
Advantage: losses and profits of
affiliated members offset each other
11-5
Nonprofit Corporations
Includes corporations formed exclusively for
“religious, charitable, scientific, literary, educational
purposes, etc.”
Section 501(c)(3) organizations require IRS
recognition of tax-exempt status
Nevertheless, tax-exempt organizations may pay
tax on “unrelated business taxable income”
11-6
Computing Corporate Taxable Income
Page 1 of the Form 1120 resembles a financial
income statement or a Schedule C in a personal
tax return (Ch 10)
See Chapters 6, 7, 8 and 9 for general rules
on business income
Corporations entitled to dividends-received deduction
Deduct charitable contributions up to 10% of taxable
income BEFORE charitable deductions and before
dividends-received deduction
Excess contributions can be carried forward for 5 years
11-7
Dividends-Received Deduction
Corporations receiving dividends from other
taxable domestic corporations are entitled to this
deduction
Ownership %
Deduction
% < 20% of stock
70% DRD
20%<= % < 80%
80% DRD
80%<= %
100% DRD
What was Congress’ reasoning behind the DRD?
To mitigate “triple” taxation
11-8
Dividends-Received Deduction Example
Aragorn Corp. owns 35% of Ent Corp. and 88% of
Legolas Corp. If Aragorn receives dividends of
$10,000 from Ent and $15,000 from Legolas,
calculate Aragorn’s DRD.
$10,000 x 80% = $ 8,000
$15,000 x 100% = $15,000
Total DRD
$23,000
11-9
Book Versus Taxable Income - Schedule M-1 & M-3
Schedules M-1 and M-3 reconcile book income to
taxable income
The M-1 was used by all corporations until 2004
and can still be used by corporations with total
assets less than $10 million
In 2004, the IRS developed the M-3 for use by
large corporations (assets > $10 million); it
requires more detailed information than the M-1
and enhances the transparency of book/tax
differences
11-10
Schedule M-1
Net book income - line 1
Federal tax expense for books - line 2
Lines 3 - 6 explain increases in taxable income
relative to books
Lines 7 - 9 explain decreases in taxable income
relative to books
Line 10 = taxable income before
NOL and DRD = Line 28, page 1,
form 1120
11-11
Example: Schedule M-1
Wilson Inc. reported $149,250 of net income after
tax on its financial statements
Wilson reported federal income tax expense of $61,250
Meals and entertainment expense = $15,000
MACRS depreciation = $60,000; book depreciation =
$42,000
Prepare Wilson Inc.’s M-1
Net book income
+ Federal tax expense
+ 50% of meals & ent.
- MACRS over SL
Taxable Income
$149,250
+ 61,250
+ 7,500
- 18,000
$200,000
11-12
Computing Regular Tax
The surtax rates of 39% and 38% eliminate bracket
benefits for ‘rich’ corporations
Corporations with taxable income
Between $335,000 and $10 million
actually pay a flat rate of 34%
Greater than $18.33 million pay a flat rate of 35%
Personal service corporations are taxed at a flat
35% rate
Includes health, law, engineering, architecture,
accounting, actuarial science, performing arts, &
consulting professionals
11-13
Domestic Production Activities Deduction
Available to US taxpayers deriving income from
domestic production activities
For 2013, deduction is equal to 9% of the lesser of
net production income or taxable income before
the deduction
Deduction can’t exceed 50% of US
compensation expense
Deduction is equivalent to a reduced
tax rate on domestic production income
11-14
Tax Credits
Credits directly reduce computed tax
$1 of credit provides $1 of benefit
$1 of deduction only provides ($1 x the tax rate) of benefit
Tax credits are generally limited to some % of tax
before credits. Often a provision
permits carry back or carry forward of
excess credits
Biggest credits: R&D credit,
foreign tax credit (see Chapter 13)
11-15
Tax Credits
To be eligible, taxpayers must engage in specific
activities that Congress believes are worthy of
government support
The list of credits changes as Congress
experiments with new credits and discards those
that fail to produce the intended behavioral result
11-16
Alternative Minimum Tax
A second federal tax system parallel to the regular
income tax
Created to ensure that every corporation pays a
“fair share” of taxes
11-17
Alternative Minimum Tax - Who is Subject?
New corporation is exempt in Year 1
Exempt in Year 2 if Year 1 sales <=$5 million
Exempt in Year 3 if average sales in years 1 and 2
<= $7.5 million
Exempt in subsequent years if average gross
receipts for three prior years <= $7.5 million
Once a corporation fails to be exempt, it is
ineligible for AMT exemption for all subsequent tax
years
11-18
Example: AMT Exemption
Year 1 sales = $4 million
Exempt from AMT because it’s year 1
Year 2 sales = $8 million
Exempt because Year 1 sales <=$5 million
Year 3 sales = $12 million
Exempt because average of years 1 and 2 = $6
million, which is <= $7.5 million
Year 4 sales = $2 million
Subject to AMT because average of years 1, 2 & 3 =
$8 million, which is > $7.5 million
Thus, the firm is subject to AMT in all
subsequent years
11-19
Alternative Minimum Tax - Overview
Alternative minimum taxable income (AMTI)
less Exemption
= AMTI in excess of Exemption
x 20%
 = Tentative minimum tax (TMT)
less Regular Tax
= Alternative minimum tax (AMT)
11-20
Alternative Minimum Taxable Income (AMTI)
Starts with regular taxable income
Add AMT preferences
Add or subtract AMT adjustments
Subtract AMT NOL
11-21
AMT Preferences
Preferences are always positive additions to AMTI
Examples
Tax-exempt interest income from private activity bonds municipal bonds issued to fund non-government activities
Percentage depletion in excess of cost basis
11-22
AMT Adjustments
Represent timing differences between regular
taxable income and alternative minimum taxable
income - will eventually reverse, perhaps over
several periods
Examples
Differences between MACRS and ADS depreciation
amounts
Completed-contract method
Amortization of pollution control facilities
ACE adjustment
11-23
ACE Adjustment
Adjustment equals 75% of difference between
‘adjusted current earnings’ and AMTI before ACE
adjustment and AMT NOL
Adjusted current earnings an economic measure of
earnings that approximates financial statement net
income
Any negative ACE adjustment (ACE > AMTI before ACE
and AMT NOL) limited to cumulative positive ACE
adjustments from prior years
11-24
AMT NOL Deduction
AMT NOL amount computed using alternative
taxable income approach
Deduction limited to 90% of AMTI before the AMT
NOL
Example: If AMTI before consideration of any NOL is
$100,000, the maximum allowable AMT NOL deduction is
$90,000
11-25
AMT - More Details
Exemption = $40,000 but is reduced by 25% of the
amount that AMTI exceeds $150,000
AMTI in excess of the Exemption is multiplied by
20% = Tentative Minimum Tax (TMT)
If TMT > Regular tax, then TMT less Regular Tax =
Alternative Minimum Tax (AMT)
If TMT < Regular tax, AMT = 0
Corporations with modest AMT adjustments and
preferences avoid AMT
11-26
AMT Timing
Minimum tax credit
Results when AMT is paid
Reduces regular tax in subsequent year
Can’t reduce regular tax to less than TMT
Carries forward indefinitely
Corporate AMT is not designed as a permanent tax
increase, but only accelerates the payment of tax
Eliminating the AMT is a frequent tax
debate in the news
11-27
Payment and Filing Requirements
Tax return due 15th day of 3rd month, may extend
to 15th day of 9th month
However, the extension does not extend the payment
deadline
Estimated payments are due on the 15th day of
4th, 6th, 9th, and 12th months
Must pay 100% of tax due; Small corporations
(TI < $1 million) may use safe-harbor rule of paying
100% of prior year tax
Underpayment penalty is computed like
interest expense but is nondeductible
11-28
Distributions to Investors
(Creditors & Shareholders)
Interest payments are deductible, while payments
on stock (i.e., dividends) are non-deductible
This creates a bias in favor of debt financing
Non-tax costs associated with debt financing
include large cash flow commitments and a greater
risk of insolvency
The non-tax costs often outweigh
the tax savings associated with debt
11-29
Alternatives to Double Taxation of Dividends
Treat corporations as pass-through entities
Administratively cumbersome, if not impossible
Make dividends nontaxable
Current policy of taxing dividends to individuals at 15% is
a step in this direction
Tax credit for individuals for the corporate tax
attributable to dividends included in individual
taxpayers’ income
All of these alternatives would result in
significant revenue loss to the Treasury
11-30
Incidence of the Corporate Tax
Corporations do not pay taxes - people do
What are examples of ways that the incidence of
the corporate tax could be born by individual
taxpayers in the U.S.?
Higher consumer prices
Lower employee wages
Lower dividends
11-31